The Euro – A Paradox Checks Into Hotel California

It could have been conceived a bit more thoughtfully, but as a project the European common currency is not altogether farfetched or indeed destined for failure. The euro was specifically created to offer an alternative to the erstwhile all-mighty US dollar as the world’s reserve currency. At the time, Europe’s leaders still entertained visions of grandeur for the continent and were able to muster the courage to pursue their ambitions.

However, be careful what you wish for. Being the issuer of the world’s reserve currency is not necessarily a blessing. It brings the dreaded Triffin Paradox into play.

Belgian-American economist Robert Triffin (1911-1993) identified a conflict of interest between desirable domestic and international monetary policies faced by any country whose legal tender is being used as the world’s reserve currency.

In order to satisfy the international demand for its currency, the US must be willing to supply the dollars required. This implies running a significant current account deficit. Domestically, the US economy would be much better served by a current account surplus.

A Paradox Explained

The Triffin Paradox was the principal cause of the demise of the Bretton Woods Era. By the early 1960s the US dollar – still on the gold standard – had become seriously overvalued. The Marshall Plan, cold war military spending, and rising imports all conspired against monetary prudence, resulting in a gaping current account deficit.

The US government tackled the issue by restricting the amount of dollars in circulation through budget cuts. It also raised interest rates in an attempt to encourage the repatriation of as many dollars as possible.

“To make matters worse, these politicians also forgot – conveniently or otherwise – to include any provisions for a euro exit should a member state fail to properly adapt to the common currency.”

US monetary policy swung from one side of the Triffin Paradox to the other, and back again, until President Richard Nixon in 1971 surprised both friend and foe by taking the dollar off the gold standard, effectively scrapping Bretton Woods by recognising that the US was no longer able to maintain anywhere near the required levels of gold reserves and trade surpluses.

There is no known solution to the dilemma first identified by Robert Triffin – it is impossible to run a current account deficit and surplus simultaneously.

For all its woes, the new-fangled euro has so far been spared a brush with the Triffin Paradox. Only about a quarter of the world’s allocated monetary reserves are currently euro denominated as opposed to 61.2% for the US dollar. This allows Europe to run sizeable current account surpluses which in turn bolster confidence in the currency’s strength. These surpluses also explain why the euro has significantly appreciated in value against the US dollar since its introduction.

A Neat Set of Tools

A current account balance expressed in solid black numbers offers central bankers an exceedingly nice and effective toolset with which to implement policy. For one, it allows them to keep interest rates low since there is absolutely no need to lure overseas deposits back home to plug any gaps. Low interest rates also make up for any loss in competitiveness suffered by a strong currency’s resistance to devaluation. The cherry on the top is, of course, the fact current account surpluses significantly contribute to a nation’s wealth.

Rather than trying to push the euro into the top-spot as the world’s reserve currency of choice, policymakers at the European Central Bank (ECB) in Frankfurt and elsewhere in the union could do worse than concentrate on the ironing-out of the many design flaws that plague the euro. It is not so much the international reputation of the euro that needs the ECB’s attention, as it is the domestic trouble the common currency causes.

With the benefit of hindsight it is rather easy to state that the euro should initially have been adopted by only a handful of EU members. As it happened, the politicians in charge of the euro project at the turn of the century opted for a silly the-more-the-merrier approach using creative bookkeeping techniques to justify the inclusion of even the most fiscally unsound member states.

Hotel California

To make matters worse, these politicians also forgot – conveniently or otherwise – to include any provisions for a euro exit should a member state fail to properly adapt to the common currency. EU countries that fail to comply with the fiscal dictates as laid down in the 1992 Maastricht Treaty may expect punishment in the form of fines and other administrative sanctions. Moreover, punishment of unruly members is meted out quite arbitrarily.

Once an EU member state has adopted the euro, it has checked into Hotel California: “You can check out any time you like, but you can never leave.” Euro countries cannot get rid of the currency other than by renouncing their membership of the union. No country, and especially not one troubled by economics woes, can seriously consider shutting itself off from a 505 million-strong market. Thus, Greece, Spain and Portugal – to name but a few – are condemned to the euro on pains of reverting back to their rather unenvious pre-EU existence.

Rather than rushing through a banking union, fiscal union, transfer union or any other half-baked plan aimed at averaging out the EU’s internal differences, the EU’s leaders should implement a much more pragmatic monetary policy that answers the concerns of voters across the union, accepts the lessons history teaches, and allows struggling nations a shot at monetary redemption.
Instead of clinging to the mistaken notion that there is no way back for any country once contaminated by the euro, policymakers would be wise to accept that some – such as Greece – are just not ready for it. However hard the authorities in Brussels, Frankfurt and Athens may try, Greece will not become a sun-bathed version of Germany anytime soon. In fact, it requires no faculty for prescience to predict that the Greek will suffer long and hard before being confronted by the obvious: It is not going to work.

Accepting the Inevitable

Why then not accept the inevitable and allow Greece to revert to its drachma which the country may then happily devalue to a point where both the trade and current account balances revert to surpluses? When faced with the consequences of their traditionally rather loose monetary policy, the Greek have always allowed the drachma to slide. And they are most assuredly not the only ones to have done so.

Even France habitually solved its many recurring issues – lagging productivity and a rather feeble level of international competitiveness – by depreciating the franc. When faced with the burst of a real estate bubble in 1992, even the Swedes – usually rather annoyingly vociferous when it comes to their supposed collective superiority – had to jack up interest rates to over 500% annually in a failed and foolish attempt to protect the kronor from implosion.

The currency slipped anyway; banks tumbled and fell left, right and centre; GDP contracted by over 5%; and their economic model – previously hailed as being close to perfect – crumbled and was unceremoniously dumped. In the end, devaluation saved the day just as it did in France, Italy, Spain, Portugal, and Greece.

In fact only a select few EU countries have been able to get ahead without falling prey to the easy cop-out of devaluation. Germany, The Netherlands and Finland spring to mind. Others like Belgium, Denmark, Austria, and quite possibly Hungary and the Baltic states, have been able to keep currency devaluations limited to within the bounds of reason. Members of both these groups would have been the natural candidates for a monetary experiment as far-reaching as the euro aims to be.

Removing the Cornerstone

As it is, the euro has been made into a cornerstone of the EU edifice. This must be undone. The common currency is to be an option for those member states that can afford it. The euro is not to be the imposition it is today.

For all their eloquence and high-mindedness, those in the pro-euro camp fail to realise that the project, due to its very nature, will drive a wedge between the countries of Northern and Southern Europe. This the continent can do without.

The brinkmanship of the pro-euro faction is entirely unwarranted and rather selfish to boot. In order to protect their access to the lucrative markets of Mediterranean Europe, countries geared for export and trade such as The Netherlands and Germany dread the day they are shut off from these avid consumers via devaluation. A severely weakened drachma would work wonders for Greece but would also make Dutch and German products and services prohibitively expensive to Greek consumers.

The Greek, however, must be allowed to do what’s in the best interest of their country and society. Right now, that best interest calls for an easy and quick fix as can only be delivered by a sharp devaluation of the means of exchange. Once the financial waters have calmed and the economy is humming again, European know-it-alls may of course dispense sound advice and apply gentle prodding to guide the country towards a more fiscally prudent lifestyle that – once attained – could very well lead to the painless adaption of a strong common currency.

It is the Greek who are most in the spotlight due to the severity of the crisis their country is being made to suffer. Their plight, however, differs but little from that of the Spanish, Portuguese, Irish, and Italians.

Interestingly enough, support for the euro is fairly high in the countries hurting the most from the monetary straightjacket imposed by Brussels. Elsewhere in the union, eurosceptics are riding the wave of popular discontent over bailout packages and plans for further EU integration and amalgamation.

Vox Populi

Whereas the Mediterranean countries have clearly shown a willingness to learn and adapt, the more monetarily prudent northern member states are reluctant teachers. In the end nobody is either happy or satisfied, making the union squeak and burst at the seams. The proposed patches – yet further integration, i.e. more of the same – run counter to public opinion in most northern member states, precisely the ones asked to foot the bill.

EU politicians need to pay much closer attention to what their voters are saying, instead of arguing that public opinion is ill-informed, motivated by emotion rather than fact, or just plain wrong. Europe – and indeed the euro project – deserves much better than to be guided by the arrogance of technocrats or those misguided souls intent on financial world domination.

Let the US deal with the contradictions of the Triffin Paradox and the many other issues arising from its status as the issuer of the world’s reserve currency. Europe has other business to attend to.